Why Natural Gas Prices will Soar in the Future

Maybe it's the gloomy Seattle weather that has made investment manager Jim Hansen and his son and partner, Kevin, at Ravenna Capital Management immune to oil and gas industry hype about the supposed U.S. shale gas "revolution." More likely it is thorough research focused on making their clients money and keeping that money out of harm's way.

The Hansens are patient contrarian investors whose time horizon is generally several years. They can't help you if you want advice on next week's or next month's natural gas price. In fact, they're not sure anyone can reliably help you with that. So they focus on much longer-term trends, and they think they've spotted one in the U.S. natural gas market.

About a year ago when domestic natural gas prices hit levels reminiscent of the 1990s, they began to move their clients into natural gas related investments. Amid the media hype about cheap natural gas for decades, they saw a different reality.

They believed that high production decline rates in shale gas wells--which now provide about 40 percent of U.S. production--were combining with rapid reductions in the drilling of new wells in a way that would eventually cause falling production and sharply rising prices. They weren't exactly clear on the timing. But, with their patient strategy, they just needed to sit and wait for what they felt was the inevitable.

"We are long-term investors and include investments that allow us to get paid to wait," Jim Hansen said, referring to securities that generate regular payouts to holders.

A year after their call, they have seemingly been vindicated as natural gas rose from a low of $1.82 per thousand cubic feet in April 2012 to over $4 currently. Prices might dip again, Jim Hansen added, but for long-term investors the trend still looks good.

What clues led the Hansens to their contrarian views? Kevin explained in one phrase: Look at what the industry does, not what it says.

While hyping the future of natural gas, the industry was doing the following:

1. Organizing their natural gas gathering systems into master limited partnerships and selling them to investors.2. Selling producing acreage to foreign investors who, believing the hype, generally overpaid.3. And when gullible foreign investors got wise, selling land packages at rock bottom prices when many companies were desperate to raise cash to meet their debt obligations.

Despite industry protestations to the contrary, all these things told Kevin Hansen that the industry "could not have been profitable." His views were eventually verified by none other than Rex Tillerson, CEO of ExxonMobil Corp., who told an audience in late June last year, "We are losing our shirts [on natural gas]."

Just recently one chastened industry executive, Matt Fox, ConocoPhillips' executive vice president of exploration and production, let slip what price level might entice companies to increase U.S. natural gas drilling again. During an April 25 conference call with analysts he had this exchange with analyst Blake Fernandez:

Fernandez: Okay. Great. Secondly, I guess it's on the natural gas side, I always view Conoco as having probably more leverage than peers do, U.S. Natural Gas, and certainly that creates some optionality. Obviously, we haven't heard anything on increased activity just yet, but is there a certain price that we should ear-mark as say, $5 [per] MCF where maybe you would begin to increase activity there?

Fox: We do have a lot of potential there, to invest. But we're really focused in on investment now on the liquids-rich assets [oil wells and also natural gas wells that yield large amounts of higher value ethane, propane, and butane] and of course we get associated gas [gas associated with oil wells] with that so we benefit from the gas price there. I would say that I wouldn't see us redirecting any capital towards gas assets until it's significantly north of the current prices. (emphasis added)

Apart from the awkward geographic analogy so popular on Wall Street these days--"north" simply means "higher"--it's not clear what "significantly" means. But since the questioner already offered the figure of $5, both Hansens believe Fox meant higher than that.

The general problem that Kevin Hansen sees is that oil and gas companies are going to continue to prefer to drill oil wells as long as the price of crude floats near the $100 level. They will be reluctant to redeploy drilling rigs to natural gas fields until higher gas prices have been sustained for quite some time, perhaps several months and maybe longer.

Add to that any of the obvious pulls on natural gas supply--a very hot summer (electricity demand from natural-gas-fired power plants), a very cold winter (heating demand) or a hurricane (damage to gas production in the Gulf of Mexico)--and you have the makings of a true crisis in supply. Even absent any of these, they expect prices to jump significantly in the coming two to three years.

So, what do things look like after we pass through the crisis? Kevin explained that he expects the natural gas price to settle at levels much higher than today. And, those prices will bring out the supply needed to meet demand. The exploitation of the country's large shale gas resource will then proceed in a more orderly fashion for several years.

But, dreams of vast, cheap supplies, say, at around $3 or $4 per thousand cubic feet, will be gone, and, with it plans for many new natural gas export terminals. Kevin believes that most of the export terminals now on the drawing board will never get funded. The math works like this: Export terminal operators generally work under cost-plus contracts. If the U.S. benchmark Henry Hub natural gas price is consistently at or above $6, then it won't be particularly competitive in Europe, an obvious market for U.S. liquefied natural gas (LNG).

After purchase it costs about another $6 to liquefy the gas, ship it and then regassify it. With European LNG prices currently running around $12 that would make U.S. imports only just competitive. Will buyers want to commit themselves to long-term cost-plus contracts with U.S. suppliers when prices have shown themselves to be so unstable as he believes they will be in the coming supply crunch?

Other pie-in-the-sky schemes that depend on cheap natural gas are likely to whither as well. He cites South African energy and chemical giant Sasol's dream of building a so-called gas-to-liquids plant in Louisiana, one that would turn natural gas into diesel and other products.

Given the high production decline rates, he believes that once U.S. shale gas resources are tapped out, "it's 2005 all over again." The country will be faced with declining natural gas production as it was in 2005, but this time with no relief in site. And unlike the industry, he doesn't think that scenario is decades away. Take the "s" off of decades, he says, and you'll likely be closer to being right about the timeline for America's next rendezvous with persistently falling domestic natural gas production.

The price of oil impacts the worldwide demand for natural gas. If oil is $100 per barrel, even at $15 per Mcf, natural gas is competitive with oil.

Ezeagu ositadinma on May 11 2013 said:

To me from production view point the demand for natural is imminent because it's economical and maximize profit which is our focus in production but the domestic and industrial importance as well as the usefulness of both needs to be considered like the secondary products of them.